Hitting Bottom

Aluminum prices fell 55 percent (from $3,380 to $1,465 per metric ton, or from $1.53 per pound to 66 cents per pound) from mid-July to late October. In just those three months, prices lost five years of gains. Prices have fallen like a rock because demand has plummeted (greatly influenced by fear and risk aversion), causing the biggest annual visible surplus on record. Prices are trading below average output cash costs ($1,550 per metric ton, or 70 cents per pound), even taking into account much lower energy and raw material prices that have resulted from the global recession.

We estimate that approximately 75 percent of global aluminum output is losing money on a cash basis (This does not take into account sustaining capital costs, depreciation nor return on capital.). Practically all output is in the red if we consider the full cost of producing aluminum. In this context, we expect prices to fall further in the next weeks, as public inventories keep growing given that output continues to lack the flexibility and speed to adjust to depressed demand.

We see $1,300 per metric ton (or 60 cents per pound) as probable in the first quarter of 2009.

Nevertheless, when we hit bottom—We believe it probably will be between the first and third quarter of 2009—we could see a "V" type violent bounce in demand and price for a number of reasons, including the historical dislocation of demand vs. its own long-term trend; the sharp distortion of prices vs. output costs; the unprecedented and aggressive stimulus programs authorities around the globe have introduced on the fiscal, monetary and financial fronts; and the lagged but still significant aluminum output curtailments and expansion deferrals that have taken place in the fourth quarter of 2008.

The consensus view is similar, forecasting a "V" bounce in prices starting in the second half of 2009. The bottom line is: Conditions are not present for a sustainable price bounce yet (prices will continue to stay low and to trend downward), but conditions are already present for a potential violent upward move later in 2009.

The main reason behind the plummeting prices has been the sharpest contraction in global demand that the aluminum market ever has experienced in a six-month period. We estimate that global demand has contracted more than 25 percent from May 2008 through December 2008. Aluminum demand from the United States and Europe is down approximately 40 percent from its peak in the second quarter of 2008.

Plummeting demand, in turn, has caused the industry’s biggest oversupply in spite of the fact that 4.4 million tons per year, or 11.5 percent of global capacity, have been curtailed (70 percent in China and 30 percent in the West) in a context where approximately 70 percent of global aluminum output is unprofitable. Every day LME (London Metal Exchange) warehouses report higher aluminum inventories. Visible aluminum inventories have increased from 3.7 weeks of consumption in the third quarter of 2008 to more than five weeks in the middle of the fourth quarter. We expected to close the year with a visible surplus of close to 1.8 million tons, the highest ever in a single year.

Demand has been hit so much that supply can’t catch up yet and will probably not catch up until demand bounces. Still, we expect another important round of aluminum output cuts in China and the West to start soon given intense economic losses that later will help prices bounce with the same violence.

What’s behind the sharp contraction in demand? The main factor behind plummeting demand has been the unprecedented increase in risk aversion and fear that the global financial crisis unleashed in early September 2008 (as measured by the VIX (Volatility Index). Just to give you an idea, at the peak of uncertainty after the terrorist attacks of Sept. 11, 2001, the VIX index increased from 20 to 40, but in less than two months, it came back to normal levels of below 30. Well, the VIX index skyrocketed from 20 in early September of 2008 to a record high of 90 by mid-October.

Collapsing confidence caused credit to dry and market participants to suspend purchases of all types of items, especially demand for big-ticket items that can be intensive in aluminum, such as autos and machinery. Additionally, the entire aluminum supply chain started to destock as much as possible, resulting in a further intensification in the fall in aluminum demand. U.S. aluminum demand from the transportation sector was down 40 percent in November vs. July, while demand from the construction sector was 34 percent lower and electrical sector demand was down by 13 percent.

We believe that confidence is today the most important variable to follow because demand will continue to trend along with this variable.

If demand is to bounce, it will have to be preceded by a sharp fall in fear and a return to normal levels of confidence. If confidence is indeed restored, we believe a subsequent sharp bounce in demand will follow.

As of early January, the VIX was trading around 43, a sharp improvement relative to November and October, for which the VIX was in the range of 80. Government actions have so far stabilized fear at lower levels. Still, there is a long road ahead of us in order to reach normal levels (below 30 as indicated by the VIX).

How long will this take? Nobody knows with certainty, but the popular consensus has that happening sometime in the first half of 2009.

Speculation continues to play a role in the aluminum market. Sophisticated speculators are as active today in commodities markets as they were before the sharp downtrend in prices started. They have passed from having long positions in metals such as aluminum (betting that prices will increase) to deep short positions (betting pries will fall). Many funds have profited greatly from plummeting prices because they have positioned themselves on the right side. Speculators simply benefit greatly from sharp and clear trends such as this one.

Our contacts in the hedge fund community confirm they have been short for some time now. A recent survey made by a prestigious European bank also shows that funds haven’t change their appetite for commodities at all and that they plan to invest close to 10 percent of their portfolios in them as a way to have exposure to emerging markets’ growth and to enhance diversification. We believe funds will continue to cause volatility and will probably provide important ammunition for a bounce in prices as sharp as the fall we have experienced. They just need evidence that demand has bottomed to switch positions. We are not there yet.

We see factors in place that could result in a potentially frightening bounce in demand and prices ahead. For instance, authorities around the globe are taking unprecedented actions on the fiscal, monetary and financial fronts to restore confidence and growth in the worldwide economy. If indeed confidence is restored (and we need to see that), we will then face the most accommodative environment for demand since the Great Depression. Additionally, a real long-term demand boom mainly from emerging countries, including China, India, Brazil, Russia, Middle East, remains unchanged in our opinion. We also must see insufficient aluminum supply and constrained capacity adjust to the upside to produce a bounce. Output cuts today equal 15 percent of global production in 2007 and will be greater than 20 percent by the time demand bounces. Additionally, the financial crisis has stopped and postponed numerous aluminum expansion projects.

When demand bounces, it will bounce considerably in a context of a really restrained and damaged supply. Re-stocking needs in the entire supply chain will intensify the bounce in demand once confidence is restored. Finally, we see China buying between 0.8 and 1.2 million tons of aluminum in 2009 for state and provincial reserves. This amount by itself is enough to reduce to less than half even the most pessimistic 2009 market surplus.

Nevertheless, a number of key unknowns persist. For instance, how effective the fiscal, financial and monetary actions taken by authorities will be to foster confidence remains to be seen. The extent of the damage to the structure of the global economy also must be determined. Also unknown are the timing and magnitude of the possible bounce in demand, China’s aluminum industry policies and the precise price at the bottom ($1,425, $1,300 or $1,000).

Although there is potential for a scary bounce in demand and prices between the second and third quarters of 2009, we need to be pragmatic and realize we still have a big global financial/confidence problem. We need tangible evidence to call an official end to this crisis of confidence and we don’t have that yet. Meanwhile, the trend in prices is officially downward.

Regardless of the precise time and level of the bottom, today’s LME aluminum prices seem tremendously cheap under almost every measurement. Even the most bearish analysts expect higher prices than the LME forward curve is offering for the 2009-2011 period. Buying at these levels implies locking in at 40 percent below last year’s price average, which is at the lowest level since 2003, and below the average cash cost of producing aluminum at a time when supply has been curtailed considerably (though not sufficiently) and when demand potentially faces the strongest underlying outlook ever given its sharp deviation vs. its own long-term trend and the unprecedented global monetary and fiscal stimuli.

Still, be aware that we don’t have enough conditions to call for a bottom and that, technically speaking, we are still heading toward $1,425 per metric ton (65 cents per pound) and probably lower.